Understanding The New Tax Law: A Q&A With David Kirk, Former IRS Attorney Turned EY Tax Partner

If you make your living in the tax world, you know David Kirk, even if you don’t think you know David Kirk.

If you’ve ever applied for a late S corporation election, you know David Kirk. If you’ve ever computed a client’s liability for the net investment income tax, you know David Kirk. And if you’ve ever been wowed by the acting chops on the guy who played Captain Kirk in that Star Trek-themed training video the IRS put out, well then, you know David Kirk.

OK, I made that last one up. But David Kirk is still one impressive dude.

After earning his undergraduate degree at Syracuse, Kirk added a law degree (University of Pittsburgh) and LLM (Georgetown) to his resume before joining the IRS as an attorney with the Office of the Chief Counsel. Within Chief Counsel, Kirk landed with the Passthroughs and Special Industries division, where he specialized in the treatment of partnerships, S corporations, estates and trusts.

While with the IRS, Kirk worked tirelessly to make our lives easier. He authored Revenue Procedure 2013-30 – which offers late relief from a missed S corporation, QSub, or entity classification election -- sparing advisors from many a rough conversation with clients.

Kirk’s magnum opus, however, was his work as the primary author of the regulations under Section 1411, the provision of the Affordable Care Act that imposes a 3.8% surtax on net investment income. At a time when practitioners were struggling to keep up with an abundance of new law – the repair regulations, the individual mandate, and the expiration of the Bush tax cuts, to name a few – Kirk’s proposed and final regulations under Section 1411 provided much needed guidance in a way advisors could understand and implement.

In March of 2014, Kirk landed at Ernst & Young LLP, where he is now a National Tax Partner in the firm’s Private Client Services group, and where he continues to focus primarily on the taxation of pass-through entities. While at EY, Kirk has continued to help the tax world make sense of the net investment income tax, authoring the Bloomberg-BNA Tax Management Portfolio on Section 1411.

But here’s what’s most impressive about David Kirk: he cares about this stuff. When Kirk published the proposed Section 1411 regulations five years ago, I endeavored to analyze and write about them for Forbes. I published a 4,000 word article, and the first piece of feedback I got was from….David Kirk. He reached out to me to offer his thoughts, letting me know what areas of the law I had interpreted correctly, and more importantly, where I may have been a bit misguided or misinterpreted his intent. Kirk viewed my article as a conduit between his work and the very people who would be tasked with implementing it, and he wanted to make sure I got it right. It was a startling display of commitment to one’s craft.

Kirk and I have stayed in touch over the years, and when the tax community was handed a Christmas present last week in the form of 500 pages of new legislative text, I knew I had to get his take on some of the more intriguing provisions.

This is the second time I’ve ventured to conduct an interview, and while Kirk may not be as swift afoot as the subject of my previous Q&A – tax geek-turned-gold medal Olympic triathlete (and fellow EYer) Gwen Jorgensen – he does offer more insight into the finer points of new Section 199A. So let’s listen to what he has to say.

Tony Nitti: First things first: you’ve recently had back surgery. How are you feeling? Should we disregard everything you have to say as being the product of a Percocet-induced haze?

David Kirk: Well, I am seven days out of back surgery, and my second for this calendar year. Apparently, once I turned 40, my spine turned to putty. I am very glad to finally have it fixed because being in pain constantly during the last several months made me a very cranky tax guy – at least that is the reason I gave my family when I got home from work every day.

Nitti: I'm glad you're coherent, because tax advisors everywhere are clamoring for a little clarity. So let’s jump into the new law: Perhaps the most controversial aspect of the Tax Cuts and Jobs Act is section 199A, a brand spankn’ new provision which, on its surface, offers a sole proprietor, shareholder in an S corporation or partner in a partnership a 20% deduction against their allocable share of business income -- or what is being called "qualified business income" (QBI). I attempted to provide some analysis here, but I barely put a dent in the uncertainty surrounding what the provision actually does. As someone who’s spent the bulk of their career in the depths of subchapters K and S, are there aspects of section 199A you think will work well? Any parts you would have done differently?

Kirk: This new section is going to be, I’d guess, the subject of the most angst for taxpayers and the IRS. To the extent that Congress touted taxpayer simplicity when discussing the bill in public, this provision is the furthest thing from that. In all likelihood, it will have its own BNA Tax Management Portfolio.

There are a few difficult aspects that the IRS and taxpayers will have to wrestle with. First, the definitional aspect: The drafters of the legislation cross-referenced section 1202(e) for a list of businesses that are not eligible for the deduction. I am not sure they realized that the laundry list of businesses in section 1202 have been on the books since 1993 and has never been defined. So I guess there is never a better time than the present to start doing it.

Consider the term brokerage – what is that? Will we know it when we see it? I see insurance brokerage and stock brokerage as falling into that definition. But what about technology companies like Uber and all of the other phone based technologies. Literally, Uber brings buyers (riders) and sellers (drivers) together – so is that a brokerage? Consider athletics? Does that mean that professional sports teams are not eligible? But what about revenue earned by local colleges and university’s using their practice facilities? What about concert revenue from stadiums?

There is probably a good reason why the IRS hasn’t defined these terms in 25 years, but this provision might have just forced their hand. Things may have been easier to implement if Congress used definitions of investment income by reference to portfolio income under section 469 instead of CFC definitions or by reference to personal service activities under the section 469 regulations instead of section 1202. But in all seriousness, the provision goes into effect virtually immediately. Taxpayers will need to make 1st quarter estimates in April 2018 and it would seem to be relevant for them to know whether they are eligible for this deduction.

The other difficulty is that it has a limit based on W-2 wages paid. In many closely held businesses, employees may be housed in a single entity, but each business line may be in a separate legal entity. There is some confusion about how this W-2 limit is going to interact with these situations.

Nitti: Ah, the W-2 limitations. Under section 199A, the 20% of QBI deduction is limited to the greater of:

50% of total W-2 wages paid by the business, or

25% of total W-2 wages plus 2.5% of the owner’s share of the unadjusted basis of certain property used in the business.

It is the last-minute addition of the “2.5% of basis” limitation that tells us that the QBI deduction is intended to apply to rental income, because landlords would be the primary beneficiary of the basis limitation. But this raises an interesting question: the 20% deduction is available only against income earned in a qualified “trade or business.” This is an ominous term in the tax law, specifically as it applies to rental income. Will rental activities have to rise to the amorphous level of a “Section 162 trade or business” for the income to be eligible for the deduction?

Kirk: As far as I can tell, section 199A only allows the 20% deduction against trade or business income – and REIT and coop dividends, but those latter two are not relevant here. In most situations, it will be easy to know if you have a trade or business on your hands. In other situations, you will not. It’s only been a hundred or so years, and we still don’t have a clear definition of a trade or business.

We had the same problem in the net investment income tax world with "trade or business." We were able to work around some of those thorny issues by deeming certain things to be trade or businesses, like in the case of self-rentals. There are two situations of rentals that are not trades or businesses, both in the triple-net lease circumstance, if I recall. So, I guess, just because you have a rental on Schedule E or an amount on Line 2 of Schedule K-1, it is not a guarantee that it is a trade or business. But even though the statute itself does not specially cross reference section 162 for the definition of trade or business, it is hard to imagine that Congress intended a standard other than that.

Nitti: Above, you said about the W-2 limitations, “In many closely held businesses, employees may be housed in a single entity, but each business line may be in a separate legal entity. There is some confusion about how this W-2 limit is going to interact with these situations.” Do you anticipate that the IRS might try to add an elective grouping opportunity similar to what is available under section 469 for passive activities?

Kirk: The way I read the section 199A rules, and the examples in the committee report, it appears that you have to test the QBI and W-2 limit on a business-by-business basis. In some of our most complicated taxpayers, that could be a hundred or more calculations. It appears that the statute gives the IRS and Treasury a fair amount of latitude to develop rules that could take into account section 469 groupings as a way to minimize the number of times a taxpayer has to do the calculation. And a grouping would also help the W-2 situation where all of the employees are in an entity, but satellite business are where the QBI is being generated.

When I get to teach this at Georgetown Law school this coming summer, this will be a good example of how fairness and simplicity tend to be on different ends of the bar bell sometimes. Hopefully the IRS will be able to the existing tools and rules that people are familiar with to minimize some of the complexity that we just inherited from this provision.

Nitti: Much has been made of the potential for abuse of the new QBI regime. What concerns you most, if anything?

Kirk: I am sure there will be aggressive positions taken on QBI – either on whether a business is eligible or the actual calculation of the base for the 20% deduction. But there is a unique deterrent baked into the law. The provision amends the rules definition of "substantial understatement of tax" when the section 199A deduction is claimed so the IRS can impose a 20% penalty easier.

Generally, section 6662 imposes a penalty equal to 20% of any underpayment of tax attributable to a substantial understatement of income tax for any year if the amount of the understatement exceeds the lesser of:

(1) 10% of the tax required to be shown on the return for the tax year or, if greater, $10,000, or

(2) $10 million.

If I am reading it correctly, if a section 199A deduction is claimed, the penalty threshold is reduced to 5% of the tax required to be shown on the return for the year. The provision aims to prevent abuse, but in my opinion, the breadth of application is much broader than it needs to be.

Consider an individual with $10 million in taxable income and a $1,000 qualified REIT dividend that is entitled to a $200 deduction, and will have to choose whether to take the $200 deduction and risk the lower, 5% substantial understatement penalty threshold, or pass on the deduction so that the understatement threshold remains 10%. Even more simply, consider the case of someone preparing their 2018 return using computer software at their kitchen table with a Form 1099 showing a $1000 REIT dividend: do you think they are going to understand that taking a $200 deduction is cutting their cushion for a 20% penalty in half?

Nitti: At the 11th hour, Congress expanded the universe of taxpayers eligible to claim the section 199A deduction to include trusts. Does this present any opportunities or challenges?

Kirk: Adding trusts and estates to taxpayer eligible for the new 20% deduction was one of the most hotly lobbied area going into the final stretch. It seems equitable to allow them the deduction.

Nitti: Tax reform isn’t all rate cuts and good news, however; there have to be revenue raisers as well. One is the 30% limitation on deductions of “net interest expense” that will apply to all businesses with average receipts in excess of $25 million. Well, I shouldn’t say “all businesses,” because as is usually the case, there are exceptions. One such exception gives a “real property trade or business” the ability to elect out of the interest limitation. That’s obviously going to be pretty attractive, but who is going to be able to meet this standard?

Kirk: The real estate lobby fought hard to get these businesses excluded from the interest expense limitation rule in new section 163(j). As you indicated, Congress accommodated their request by excepting from the interest limit so-called “real property trade or businesses” described in section 469(c)(7)(C). Those include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Again, like we were talking about for QBI and the cross reference to section 1202, these 11 items were added to the code in 1993 and have never been defined. In fact, there was a project inside the IRS to define these terms about 6 or 7 years ago, but it became too complicated and the line-drawing became too arbitrary. Originally, this concept of a "real property trade or business" applied solely to individuals, but because new section 163(j) chose to use the same definition and cross reference to section 469, we have all sort of business coming out of the woodwork asking if they are one of these 11 businesses. The IRS has a real headache on their hands.

Nitti: I see your point. Under current law, the definition of “real property trade or business” has largely only been an issue for brokers and agents who want to qualify as a real estate professional so they can take a loss from their rental properties. Now, whether a business meets the standard of a “real property trade or business” is going to determine whether billion dollar corporations have to take a haircut on their interest expense deductions. There’s a lot more at stake now. You’re a smart guy; any suggestions on how you’d approach the definitional aspect?

Kirk: I tried defining the eleven terms when I was in the IRS. I felt like I was the tax reincarnation of General George Pickett, charging across a grassy field trying to get over a small brick wall with “IRC 469(c)(7)(C)” written on it. I think I got to about 11 pages single spaced….but I wasn’t totally sure I got everything. Just in the last week I heard questions about whether toll roads & toll bridges owned by private equity infrastructure funds could qualify. The only thing I know for sure is that I never even thought about those cases.

Nitti: So from what I'm hearing from you, the first items on the IRS "to-do" list is to further define "service businesses" for purposes of section 199A and "real property trade or businesses" for purposes of section 163(j). One revenue raiser that hasn’t gotten enough attention is the new limitation of $500,000 ($250,000 if single) on "active" business losses. We’re used to having limitations on losses when someone is a passive owner, but now even a non-passive owner will be capped at how much loss can be used to offset other sources of income. What are your thoughts on new section 461(l)?

Kirk: This provision caught just about everyone by surprise. When you couple this with the 80% limit on the use of NOLs, it effectively requires almost everyone to pay taxes every year when those types have traditionally not paid tax in prior years. We’ve seen some people with multi-million dollar swings in cash tax liabilities when these two provisions are combined. Although you try to explain to clients that these are timing differences and they’ll pay less taxes later, that still doesn’t sit well when they are writing checks today.

Nitti: This bill went from inception to passage at the speed of light. I think most within the industry are already anticipating the “Technical Corrections Act of 2018.” But will cleaning up the inevitable mistakes in the legislation be as simple as that? Or will there be political hurdles?

Kirk: Technical corrections will be needed, there is little question about that. There are also technical corrections needed for the new partnership audit regime going into effect on January 1 2018, so maybe these can be merged together. I don’t think that the Senate can pass a technical corrections with only 50 votes, so maybe it will need to be attached to something that Democrats support to get it through.

Nitti: You were the architect behind the Section 1411 regulations governing net investment income tax, so you know better than anyone what the IRS is now tasked with in terms of providing guidance for tax advisors and taxpayers as to how to interpret the new law. What is a realistic timeline for regulations? What do we do until then?

Kirk: The IRS is going to have their hands full this year. The last time they had a big legislative challenge with the Affordable Care Act, it was very different. The ACA was phased in over multiple years, so it gave them time to develop forms and instructions and regulations in a thoughtful and deliberate manner. And seven years ago, they had thousands more employees to do that work and hundreds of millions in additional financial resources from Congress. This time around, they are lacking time, staff, and funding. By way of reference, the proposed regulations for the NIIT took 26 months to develop, the final regulations took 50 weeks, and the form and associated computer programming took several years. And the 2013 proposed regulations still haven’t been finalized four years later.

I would expect that for complex provisions like the 20% deduction under section 199A, they would issue administrative notices that will provide interim guidance and also request for public comments. I would expect these in the second quarter. At the same time, the IRS will need to be changing forms and editing instructions. Draft forms and instructions usually come out in the fall. Those drafts are critically important because the software vendors use those to begin programming software. Regulations and other types of more permanent guidance will trickle out over the next 12-24 months, but I wouldn’t expect to have much clarity on the thorniest of issues by the time the 2018 returns are due in October 2019. These timelines are not terribly uncommon for new laws, it is simply the sheer number of changes that will make 2018 and 2019 a pretty interesting couple years.

Nitti: David, thanks so much for providing your insight during a time when, quite frankly, many of us are feeling overwhelmed by what was just handed down. Final, and perhaps most vexing, question: until 2011, Syracuse, Pitt, and Georgetown were all part of the Big East Conference for basketball. How on earth did you decide who to root for when the conference tournament hit Madison Square Garden every spring?

Kirk: I had two rules. I would root for Syracuse, Pitt and Georgetown, in that order, because it was based on time (and money) spent at each school. But when it came to a head-to-head match-up, I would take into consideration who was ranked higher in the Associated Press Top 25 poll, then I would deviate from the general rule if the loss by the higher ranked team would have hurt that team more than the win would have helped the other team. So if Pitt were ranked 3rd and the 'Cuse 15th, I'd pull for Pitt so they could retain their lofty ranking, even though I'd spent more time and money at Syracuse. And yes, I had too much free time on my hands back then. That's certainly not an issue anymore.

I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and part...